What it is:
A wash-out round is a round of financing that dilutes the original shareholders so much that their voting power is essentially "washed out."
How it works (Example):
For example, let's assume that John starts Company XYZ, which makes a novel new product for wine-lovers. John receives a massive order from Macy's, but in order to make the product and turn a huge profit, he needs $1.5 million to buy equipment and hire five new people.
John goes to an investing conference and meets three wealthy angel investors. They offer to invest $2 million in the company in return for 75% of the equity in Company XYZ. This would leave John as a 25% owner of the company he started. With only 25% of the company under his control, John will not be able to outvote the three new investors if he disagrees with a decision they want to make. The $2 million he raised from outside investors was a wash-out round.
Why it Matters:
Wash-out rounds are often hard for entrepreneurs to stomach because it often means giving up control of their companies. Entrepreneurs that were essentially "one-man shows" can find themselves being steamrolled by outside investors, or maybe even fired. It's no mistake that wash-out rounds are sometimes called "cram-downs."
From a financial perspective, a wash-out round isn't always bad. In John's case, if the $2 million investment eventually grows the firm into a $12 million company, then John comes out ahead: 25% of $12 million ($3 million) is worth more than 100% of $2.67 million. (Note: When the investors in our example bought 75% of the company for $2 million, that meant they valued the whole company at $2.67 million.)